SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Act of
1934
For the quarterly period ended June 30, 2002.
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934.
Commission File Number 000-23775
APPROVED FINANCIAL CORP.
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(Exact Name of Registrant as Specified in its Charter)
VIRGINIA 52-0792752
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(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification Number)
1716 Corporate Landing Parkway, Virginia Beach, Virginia 23454
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(Address of Principal Executive Office) (Zip Code)
757-430-1400
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(Registrant's Telephone Number, Including Area Code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant is
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No __.
Indicate the number of shares outstanding of each of the registrant's classes of
common stock, as of August 1, 2002: 5,482,114 shares
1
APPROVED FINANCIAL CORP.
INDEX
PAGE
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets -
June 30, 2002 and December 31, 2001 4
Consolidated Statements of Operations and Comprehensive Loss -
Three months ended June 30, 2002 and 2001 5
Consolidated Statements of Operations and Comprehensive Loss -
Six months ended June 30, 2002 and 2001 6
Consolidated Statements of Cash Flows -
Six months ended June30, 2002 and 2001 7
Notes to Consolidated Financial Statements 8
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 12
Item 3. Quantitative and Qualitative Disclosures About Market
Risk 28
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 30
Item 2. Changes in Securities 30
Item 3. Defaults Upon Senior Securities 30
Item 4. Submission of Matters to a Vote of Security Holders 30
Item 5. Other Information 30
Item 6. Exhibits and Reports on Form 8-K 30
2
PART I. FINANCIAL INFORMATION
3
APPROVED FINANCIAL CORP.
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except per share amounts)
June 30, 2002 December 31, 2001
-------------- -----------------
(Unaudited)
ASSETS
Cash $ 17,923 $ 11,627
Investments 1,056 1,056
Mortgage loans held for sale, net 21,283 47,886
Mortgage loans held for yield, net 7,976 10,348
Real estate owned, net 1,052 589
Deferred tax asset, net - 1,607
Premises and equipment, net 3,463 3,793
Other assets 1,619 1,619
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Total assets $ 54,372 $ 78,525
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LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Money market deposits $ 1,653 $ 2,232
Certificates of deposits 38,939 59,903
Revolving warehouse loan 3,123 3,280
Subordinated debt - promissory notes 2,529 2,499
Subordinated debt - certificate of indebtedness 2,152 2,063
Mortgage note payable 1,713 1,745
Accrued and other liabilities 1,413 1,420
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Total liabilities 51,522 73,142
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Shareholders' equity:
Preferred stock series A, $10 par value; 1 1
Non-cumulative, voting:
Authorized shares - 100
Issued and outstanding shares - 90
Common stock, par value - $1 5,482 5,482
Authorized shares - 20,000,000
Issued and outstanding shares - 5,482,114
Additional capital 552 552
Retained deficit (3,185) (652)
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Total shareholders' equity 2,850 5,383
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Total liabilities and shareholders' equity $ 54,372 $ 78,525
============== =================
The accompanying notes are an integral part of the consolidated financial
statements.
4
APPROVED FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE (LOSS) INCOME
(In thousands, except per share amounts)
(Unaudited)
Three Months Ended June 30,
---------------------------
2002 2001
----------- ------------
Revenue:
Gain on sale of loans $ 1,802 $ 5,179
Interest income 1,061 1,618
Other fees and income 383 942
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3,246 7,739
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Expenses:
Compensation and related 1,505 2,777
General and administrative 1,109 1,549
Interest expense 770 1,122
Loan production expense 304 690
Write down of goodwill - 845
Write down of fixed assets - 106
Provision for loan losses 9 321
----------- ------------
3,697 7,410
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(Loss)/Income before income taxes (451) 329
Income tax expense 1,333 124
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Net (loss)/income (1,784) 205
Other comprehensive income, net of tax:
Unrealized gain on securities - 2
----------- ------------
Comprehensive (loss)/income $ (1,784) $ 207
=========== ============
Net (loss)/income per share:
Basic and Diluted $ (0.33) $ 0.04
=========== ============
Weighted average shares outstanding:
Basic and Diluted 5,482 5,482
=========== ============
The accompanying notes are an integral part of the consolidated financial
statements.
5
APPROVED FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE (LOSS) INCOME
(In thousands, except per share amounts)
(Unaudited)
Six Months Ended June 30,
--------------------------
2002 2001
----------- -----------
Revenue:
Gain on sale of loans $ 3,740 $ 7,956
Interest income 2,284 2,871
Other fees and income 862 1,601
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6,886 12,428
----------- -----------
Expenses:
Compensation and related 3,084 5,469
General and administrative 2,266 3,235
Interest expense 1,713 1,997
Loan production expense 649 1,038
Write down of goodwill - 845
Write down of fixed assets - 106
Provision for loan losses 99 433
----------- -----------
7,811 13,123
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Loss before income taxes (925) (695)
Income tax expense (benefit) 1,608 (254)
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Net loss (2,533) (441)
Other comprehensive income, net of tax:
Unrealized gain on securities - 9
----------- -----------
Comprehensive loss $ (2,533) $ (432)
=========== ===========
Net loss per share:
Basic and Diluted $ (0.46) $ (0.08)
=========== ===========
Weighted average shares outstanding:
Basic and Diluted 5,482 5,482
=========== ===========
The accompanying notes are an integral part of the consolidated financial
statements.
6
APPROVED FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
Six Months Ended June 30,
--------------------------
2002 2001
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Operating activities
Net loss $ (2,533) $ (441)
Adjustments to reconcile net loss to net
Cash used in operating activities:
Depreciation of premises and equipment 332 330
Amortization of goodwill - 58
(Recovery) provision for loan losses (181) 359
Provision for losses on real estate owned 280 73
Deferred tax expense 1,607 188
Loss on real estate owned 103
Proceeds from sale and prepayments of loans 139,952 190,786
Originations of loans, net (108,195) (205,455)
Loss on sale/disposal of fixed assets - 1
Gain on sale of loans (3,740) (7,956)
Loss on write down of goodwill - 845
Loss on write down of fixed assets - 106
Changes in assets and liabilities:
Loan sale receivable - (1,254)
Income tax receivable - (443)
Other assets - (273)
Accrued and other liabilities (7) 15
----------- -----------
Net cash provided by (used in) operating activities 27,618 (23,061)
Cash flows from investing activities:
Purchase of premises and equipment (4) (72)
Sales of premises and equipment 2 166
Sales of real estate owned 318 664
Real estate owned capital improvements (25) (97)
Purchases of FHLB stock - (467)
Net decrease in ARM fund shares - 2,265
----------- -----------
Net cash provided by investing activities 291 2,459
Cash flows from financing activities:
Net (decrease) increase in borrowings - warehouse (157) 1,591
FHLB and LOC repayments, net - (3,000)
Principal payments on mortgage notes payable (32) (339)
Net increase (decrease) in:
Notes payable 30 (148)
Certificates of indebtedness 89 143
Certificates of deposit (20,964) 28,697
Money market (579) (1,126)
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Net cash (used in) provided by financing activities (21,613) 25,818
----------- -----------
Net increase in cash 6,296 5,216
Cash at beginning of period 11,627 7,597
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Cash at end of period $ 17,923 $ 12,813
=========== ===========
Supplemental cash flow information:
Cash paid for interest 1,713 $ 831
Cash received from income taxes 15 -
Supplemental non-cash information:
Loan balances transferred to real estate owned 1,037 $ 175
The accompanying notes are an integral part of the consolidated financial
statements.
7
APPROVED FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Six months ended June 30, 2002 and 2001
NOTE 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
Organization: Approved Financial Corp., a Virginia corporation ("Approved"), and
its subsidiaries (collectively, the "Company") operate primarily in the consumer
finance business of originating, servicing and selling mortgage loans secured
primarily by first and second liens on one-to-four family residential
properties. The Company sources mortgage loans through two origination channels;
a network of mortgage brokers who refer mortgage customers to the Company
("broker" or "wholesale") and an internal sales staff that originate mortgages
directly with borrowers ("retail" and "direct"). Approved has two wholly owned
subsidiaries through which it originated residential mortgages during the years
of 2002 and 2001, Approved Federal Savings Bank (the "Bank") is a federally
chartered thrift institution, and Approved Residential Mortgage, Inc. ("ARMI").
ARMI had no active loan origination operations for the six months ended June 30,
2002. Approved has a third wholly owned subsidiary, Approved Financial Solutions
("AFS"), through which it offers other financial products such as Debt Free
Solutions, Mortgage Acceleration Program and insurance products to its mortgage
customers.
Principles of accounting and consolidation: The consolidated financial
statements of the Company include the accounts of Approved and its wholly-owned
subsidiaries. All significant inter-company accounts and transactions have been
eliminated.
Use of estimates: The preparation of financial statements in conformity with
accounting principles generally accepted in the United States of America (US
GAAP) requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosure of contingent assets
and liabilities at the date of the financial statements and the reported amounts
of revenues and expenses during the reporting period. Actual results could
differ from those estimates.
Cash and cash equivalents: Cash and cash equivalents consist of cash on deposit
at financial institutions and short-term investments that are considered cash
equivalents if they were purchased with an original maturity of three months or
less.
Loans held for sale: Loans, which are held for sale, are carried at the lower of
aggregate cost or market value. Market value is determined by current investor
yield requirements and net realizable values for loans in special circumstance.
Loans held for yield: Loans are stated at the amount of unpaid principal less
net deferred fees and an allowance for loan losses. Interest on loans is accrued
and credited to income based upon the principal amount outstanding. Fees
collected and costs incurred in connection with loan originations are deferred
and recognized over the term of the loan.
Allowance for loan losses: The allowance for loan losses ("ALLL") is maintained
at a level believed adequate by management to absorb probable inherent losses in
the held for yield loan portfolio at the balance sheet date. Management's
determination of the adequacy of the allowance is based on an evaluation of the
current loan portfolio characteristics including criteria such as delinquency,
default and foreclosure rates and trends, credit grade of borrowers, loan to
value ratios, current economic and secondary market conditions, regulatory
guidance and other relevant factors. The allowance is increased by provisions
for loan losses charged against income. Loan losses are charged against the
allowance
8
when management believes it is unlikely that the loan is collectable. Prior to
the third quarter of 2001, the ALLL reflected loan loss reserves for all loans
including held for yield and held for sale.
Valuation Allowance: Beginning in the third quarter of 2001, as of each
financial reporting date, management evaluates and reports all held for sale
loans at the lower of cost or market value. Any decline in value, including
those attributable to credit quality, are accounted for as a charge to provision
for valuation allowance for held-for-sale loans, not as adjustments to the ALLL.
Such provision is charged against income and not reported as part of ALLL, and
therefore is not eligible for inclusion in Tier 2 capital for risk based capital
purposes. Valuation allowances are established based on the age of the loan as
well as special circumstances known to management that merit a valuation
allowance. Loans held 90 days or less that do not fall into a special
circumstance category are carried at cost. A valuation allowance is charged
against first lien and subordinate liens non-conforming mortgage loans held over
90 days that do not fall into a special circumstance category. All loans
considered to be special circumstance are carried at the net realizable value.
The net realizable value represents the current appraised or listed property
valuation less estimated cost to liquidate the property. The difference in the
principal value of the loan and the net realizable value is recorded as a
Valuation Allowance.
Origination fees: Net origination fees are recognized over the life of the loan
or upon the sale of the loan, if earlier.
Real estate owned: Assets acquired through loan foreclosure are recorded as real
estate owned ("REO") at the lower of cost or fair market value, net of estimated
disposal costs. Cost includes loan principal and certain capitalized
improvements to the property. The estimated fair market value is reviewed
periodically by management, and any write-downs are charged against current
earnings using a valuation account, which has been netted against real estate
owned in the financial statements.
Premises and equipment: Premises, leasehold improvements and equipment are
stated at cost less accumulated depreciation and amortization. The buildings are
depreciated using the straight-line method over thirty and thirty-nine years.
Leasehold improvements are amortized over the lesser of the terms of the lease
or the estimated useful lives of the improvements. Depreciation of equipment is
computed using the straight-line method over the estimated useful lives of three
to five years. Expenditures for betterments and major renewals are capitalized
and ordinary maintenance and repairs are charged to operations as incurred.
Investments: The Company's investment in the stock of the Federal Home Loan Bank
("FHLB") of Atlanta is stated at cost.
All other investment securities, except the FHLB stock, are classified as
available-for-sale and reported at fair value, with unrealized gains and losses
excluded from earnings and reported as other comprehensive income in
shareholders' equity. Realized gains and losses on sales of securities are
computed using the specific identification method.
Loan originations and income recognition: The Company applies a
financial-components approach that focuses on control when accounting and
reporting for transfers and servicing of financial assets and extinguishments of
liabilities. Under that approach, after a transfer of financial assets, an
entity recognizes the financial and servicing assets it controls and the
liabilities it has incurred, derecognizes financial assets when control has been
surrendered, and derecognizes liabilities when extinguished. This approach
provides consistent standards for distinguishing transfers of financial assets
that are sales from transfers that are secured borrowings. Gains on the sale of
mortgage loans, representing the difference between the sales proceeds and the
net carrying value of the loans, are recognized when mortgage loans
9
are sold and delivered to investors.
Interest on loans is credited to income based upon the principal amount
outstanding. Interest is accrued on loans until they become 60 days or more past
due.
Advertising costs: Advertising costs are expensed when incurred.
Income taxes: Taxes are provided on substantially all income and expense items
included in earnings, regardless of the period in which such items are
recognized for tax purposes. The Company uses an asset and liability approach
that requires the recognition of deferred tax assets and liabilities for the
estimated future tax consequences of events that have been recognized in the
Company's financial statements or tax returns. In estimating future tax
consequences, the Company generally considers all expected future events other
than enactments of changes in the tax laws or rates. The Company maintains a
valuation allowance based upon an assessment by management of future taxable
income and its relationship to realizability of deferred tax assets. The effect
on deferred taxes of a change in tax rates is recognized in income in the period
that includes the enactment date.
Earnings per share: The Company computes "basic earnings per share" by dividing
income available to common shareholders by the weighted-average number of common
shares outstanding for the period. "Diluted earnings per share" reflects the
effect of all potentially dilutive potential common shares such as stock options
and warrants and convertible securities.
Comprehensive Income: The Company classifies items of other comprehensive income
by their nature in the financial statements and displays the accumulated balance
of other comprehensive income separately from retained earnings and additional
capital in the equity section of the consolidated balance sheets. The only item
the Company has in Comprehensive Income or Loss for the six months ended June
30, 2001, is unrealized gains on securities, net of deferred taxes. For the six
months ended June 30, 2002, we had no other comprehensive income or loss.
Goodwill recognition policy: Goodwill represents the excess of purchase price
and related costs over the value assigned to the net tangible and intangible
assets of businesses acquired. Periodically, the company reviews the
recoverability and the estimated remaining life of goodwill. The measurement of
possible impairment is based primarily on the ability to recover the balance of
the goodwill from expected future operating cash flows on an undiscounted basis.
Liquidity: The Company finances its operating cash requirements primarily
through certificates of deposit, warehouse credit facilities, and other
borrowings. Our borrowings were 92.2% of total assets at June 30, 2002, compared
to 91.3% at December 31, 2001.
Segments: A public business enterprise is required to report financial and
descriptive information about its reportable operating segments. Operating
segments are components of an enterprise about which separate financial
information is available that is evaluated regularly by the chief operating
decision-maker in deciding how to allocate and in assessing performance.
Generally, financial information is required to be reported on the basis that it
is used internally for evaluating segment performance and deciding how to
allocate resources to segments. The Company has evaluated this requirement and
determined it operates in one segment.
Reclassifications: Certain 2001 amounts have been reclassified to conform to the
2002 presentation.
10
New accounting pronouncements: In September 2000, the FASB issued SFAS No. 140,
Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities, a replacement of SFAS No. 125. It revises the standards for
accounting for securitizations and other transfers of financial assets and
collateral and requires certain disclosures, but it carries over most of
provisions of SFAS No. 125 without reconsideration. The Statement requires a
debtor to reclassify financial assets pledged as collateral and report these
assets separately in the statement of financial position. It also requires a
secured party to disclose information, including fair value, about collateral
that it has accepted and is permitted by contract or custom to sell or repledge.
The Statement includes specific disclosure requirements for entities with
securitized financial assets and entities that securitize assets. This Statement
is effective for transfers and servicing of financial assets and extinguishments
of liabilities occurring after March 31, 2000 and is effective for recognition
and reclassification of collateral and for disclosures relating to
securitization transactions and collateral for fiscal years ending after
December 15, 2000. The adoption of FAS 140 did not have a material effect on
financial condition or results of operation of the Company.
In July 2001, FASB issued SFAS No. 142, "Goodwill and Other Intangible Assets."
SFAS No. 142 requires the use of a non-amortization approach to account for
purchased goodwill and certain intangibles, effective January 1, 2002. The
adoption of this pronouncement did not have a material impact on our financial
statements.
NOTE 2. BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have been
prepared in accordance with US GAAP for interim financial information and with
the instructions to Form 10Q and Article 10 of Regulation S-X. Accordingly, they
do not include all of the information and footnotes required by US GAAP for
complete financial statements. In the opinion of management, all adjustments
(consisting of normal recurring accruals) considered necessary for a fair
presentation have been included. Operating results for the six month period
ended June 30, 2002 are not necessarily indicative of the results that may be
expected for the year ending December 31, 2002. For further information, refer
to the consolidated financial statements and footnotes thereto included in the
Company's annual report on Form 10-K for the year ended December 31, 2001.
11
ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following financial review and analysis of the financial condition and
results of operations, for the six months ended June 30, 2002 and 2001 should be
read in conjunction with the consolidated financial statements and the
accompanying notes to the consolidated financial statements, and other detailed
information appearing in this document.
GENERAL
Approved Financial Corp. ("AFC", "Holding Company", "Parent Company") is a
Virginia-chartered financial institution, principally involved in originating,
purchasing, servicing and selling loans secured primarily by conforming and
non-conforming first and junior liens on owner-occupied, one-to-four-family
residential properties. We offer both fixed-rate and adjustable-rate loans for
debt consolidation, home improvements, purchase and other purposes. Through our
retail division we also originate, service and sell government mortgage products
such as VA and FHA. The term "non-conforming" as used in this report relates to
a borrower that for various reasons may not fit the underwriting guidelines of
traditional conforming/ government agency mortgage products, but who exhibits
the ability and willingness to repay the loan.
We utilize wholesale (through mortgage brokers) and retail (direct to the
consumer) channels to originate mortgage loans. At the broker level, an
extensive network of independent mortgage brokers generates referrals.
In the six months ended June 30, 2002, the dollar volume in the wholesale
lending division accounted for 95.0% of total originations and the retail
lending division accounted for 5.0% of total originations. In the six months
ended June 30, 2001, the dollar volume in the wholesale lending division
accounted for 67.8% of total originations and the retail lending division
accounted for 32.2% of total originations. Our current initiatives for the
mortgage business focus on increasing future origination volume in a
cost-effective manner primarily through the wholesale channel.
Once loan application packages are received from the wholesale and retail
networks, the underwriting risk analysis and the processing of required
documentation are completed and the loans are funded. We typically package the
loans and sell them on a whole loan basis to institutional investors consisting
primarily of larger well-capitalized financial institutions and reputable
mortgage companies. We sell conforming loans to large financial institutions and
to government and quasi-government agencies. The proceeds from these sales
release funds for additional lending and operational expenses.
We historically have derived our income primarily from the premiums received on
whole loan sales to institutional investors, net interest earned on loans held
for sale, net interest income on loans held for yield, various origination fees
received as part of the loan application and closing process and to a lesser
extent from ancillary fees from servicing activity related to loans held for
yield and loans held for sale and from other financial services offered in past
periods. In future periods, we may generate revenue from loans sold through
alternative loan sale strategies, from other types of lending activity and from
the sale of other financial products and services that are permissible
activities for a Bank or Bank Holding Company.
12
RESULTS OF OPERATIONS
NET INCOME (LOSS)
For the three months ended June 30, 2002, we reported a net loss of $1.8 million
compared to net income of $0.2 million for the three months ended June 30, 2001.
For the six month period ended June 30, 2002, we reported a net loss of $2.5
million compared to a $0.4 million net loss in 2001. On a per share basis, the
net loss for the three months ended June 30, 2002 was $0.33 compared to net
income of $0.04 for the same period in 2001. On a per share basis the net loss
for the six months ended June 30, 2002 was $0.46 compared to $0.08 for 2001. The
net loss increased primarily due to an increase in the deferred tax valuation
allowance in the six-months ended June 30, 2002 of $1.7 million.
ORIGINATION OF MORTGAGE LOANS
The following table shows the loan originations in dollars and units for our
wholesale and retail divisions for the three and six months ended June 30, 2002
and 2001. The retail division originates mortgages that are funded in-house and
through other lenders ("brokered loans"). Brokered loans consist primarily of
mortgages that do not meet our underwriting criteria or product offerings.
Three Months Ended Six Months Ended
(Dollars in millions) June 30, June 30,
------------------- -------------------
2002 2001 2002 2001
------------------- -------------------
Dollar Volume of Loans Originated:
Broker $ 44.3 $ 101.5 $ 103.5 $ 146.7
Retail funded through other lenders 0.4 6.4 0.7 11.0
Retail funded in-house non-conforming 0.3 3.8 0.7 8.8
Retail funded in-house conforming and government 1.0 28.0 4.0 49.9
------------------- -------------------
Total $ 46.0 $ 139.7 $ 108.9 $ 216.4
=================== ===================
Number of Loans Originated:
Broker 522 908 1,150 1,409
Retail funded through other lenders 4 49 6 108
Retail funded in-house non-conforming 1 62 4 136
Retail funded in-house conforming and government 8 211 30 383
------------------- -------------------
Total 535 1,230 1,190 2,036
=================== ===================
The dollar volume of loans originated in the three and six months ended June 30,
2002 (including retail loans brokered to other lenders) decreased 67.1% and
49.7%, respectively, when compared to the same period in 2001. The decrease in
loan originations was primarily due to reduction in retail loan origination
offices from nine (9) at the beginning of year 2001 to one (1) at the beginning
of year 2002 and, the closure in April 2002 of the previous West wholesale
operation. A new California wholesale operations center was established in July
2002 and is currently under development.
The dollar volume of loans funded in-house decreased 65.8% and 47.3% in the
three and six months ended June 30, 2002 compared to the same period in 2001,
primarily due to the reduction in retail loan origination centers. Brokered
loans generated by the retail division were $0.4 million and $0.7 million during
the three and six months ended June 30, 2002, which was a 93.8% and 93.6%
decrease compared to $6.4 and $11.0 million during the same period in 2001.
13
The decrease in retail loan origination centers resulted in a 92.3% decrease in
our retail loan volume including retail loans brokered to other lenders for the
six months ended June 30, 2002 when compared to the same period in 2001.
The volume of loans originated through the Company's wholesale division, which
originates loans through referrals from a network of mortgage brokers, decreased
56.4% and 29.4% to $44.3 million and $103.5 million for the three and six months
ended June 30, 2002, compared to $101.5 million and $146.7 million for the three
and six months ended June 30, 2001. The decrease was primarily the result of the
company closing down the West wholesale division. As of third quarter 2002, a
new California operations center is under development.
GAIN ON SALE OF LOANS
The largest component of our net income is gain on sale of loans. There is an
active secondary market for residential mortgage loans. Under our current
business strategy, we originate loans to be sold to other financial
institutions. We receive cash at the time loans are sold. The loans are sold
service-released on a non-recourse basis, except for normal representations and
warranties, which is consistent with industry practices. By selling loans in the
secondary mortgage market, we are able to obtain funds that may be used for
additional lending and investment purposes. Gain on sale of loans is comprised
of several components, as follows: (a) the difference between the sales price
and the net carrying value of the loan; plus (b) loan origination fee income
collected at loan closing and deferred until the loan is sold; less (c) loan
sale recapture premiums and loan selling costs.
Nonconforming loan sales totaled $53.0 million and $127.3 million for the three
and six months ended June 30, 2002, compared to $92.3 million and $136.2 million
for the same period in 2001.
For the three and six month period ended June 30, 2002, we sold $4.3 million and
$4.3 million of seasoned loans at a weighted average discount to par value of
2.2% and 2.2%. For the three and six month period ended June 30, 2001, we sold
$0.7 and $1.2 million of seasoned loans at a weighted average discount to par
value of 5.3% and 5.4%.
Conforming and government loan sales were $2.1 million and $5.9 million for the
three and six months ended June 30, 2002, compared to $26.2 million and $44.5
million for the three and six months ended June 30, 2001.
The combined gain on the sale of loans was $1.8 million and $3.7 million for the
three and six months ended June 30, 2002, which compares with $5.2 million and
$8.0 million for the same period in 2001. The decrease in the combined gain on
sale of loans was primarily the result of a reduction in loan volume and a
change in the mix of loans sold shifting away from retail loans to wholesale
loans. Retail origination fees and points earned at time of origination are
recognized at the time of sale and included in the gain on sale calculation. For
the three and six months ended June 30, 2002, approximately 95.2% and 95.5% of
loans sold (conforming & non-conforming) were originated by the wholesale
division, compared to 90.8% and 87.9% for the three and six months ended June
30, 2001. Gain on the sale of mortgage loans represented 55.5% and 54.3% of
total revenue for the three and six months ended June 30, 2002, compared to
66.9% and 64.0% of total revenue for the same period in 2001. This was primarily
a result of reduced loan sale premiums.
The weighted-average premium, realized on non-conforming loan sales was 3.58%
and 2.80%, during the three and six months ended June 30, 2002, compared to
4.21% and 4.15% (excluding seasoned loan sales) for the same period in 2001. The
weighted-average premium realized on its conforming and
14
government loans sales was 1.63% and 1.72% during the three and six months ended
June 30, 2002, compared to 1.40% and 1.55% for the three and six months ended
June 30, 2001. The reduction in the weighted-average premium percent received on
loan sales was primarily the result of the sale of loans during 2002, which were
funded as part of a short-term promotional loan product offered in December 2001
and January 2002 that yielded lower premiums.
We defer recognizing income from the loan origination fees we receive at the
time a loan is closed. These fees are recognized over the lives of the related
loans as an adjustment of the loan's yield using the level-yield method.
Deferred income pertaining to loans held for sale is taken into income at the
time of sale of the loan. Origination fee income is primarily derived from our
retail lending division. Origination fee income included in the gain on sale of
loans for the three and six months ended June 30, 2002 was $0.2 million and $0.3
million, compared to $1.0 million and $1.8 million for the three and six months
ended June 30, 2001. The decrease is the result of a decrease in the volume of
loans sold, which were generated by our retail division. Average origination fee
income from conforming and government loans was 1.10% and 0.90% for the three
and six months ended June 30, 2002 compared to 2.25% and 2.26% for the three and
six months ended June 30, 2001. Costs associated with selling loans were
approximately 5 basis points for the three and six months ended June 30, 2002
compared to 4 basis points for the three and six months ended June 30, 2001.
We also defer recognition of the expense incurred, from the payment of fees to
mortgage brokers, for services rendered on loan originations. These costs are
deferred and recognized over the lives of the related loans as an adjustment of
the loan's yield using the level-yield method. The remaining balance of expenses
associated with fees paid to brokers is recognized when the loan is sold.
Average services rendered fees paid on mortgage broker referral originations for
the three and six months ended June 30, 2002 was 33 and 26 basis points compared
to 64 and 65 basis points for the three and six months ended June 30, 2001.
INTEREST INCOME AND EXPENSE
Interest income for the three and six months ended June 30, 2002 was $1.1
million and $2.3 million compared with $1.6 million and $2.9 million for the
same period ended in 2001. The decrease in interest income for the three and six
months ended June 30, 2002 was due to a lower average interest rate on loans
held for sale and a decrease in loans receivable.
Interest expense for the three and six months ended June 30, 2002 was $0.8
million and $1.7 million compared with $1.1 million and $2.0 million for the
three and six months ended June 30, 2001. The decrease in interest expense was
due to a decrease in loan origination and loans receivable.
Changes in the average yield received on the loan portfolio, as mortgages are
based on long term borrowing rates, may not coincide with changes in interest
rates we must pay on revolving warehouse loans, the Bank's FDIC-insured
deposits, and other borrowings, which are primarily based on short term
borrowing rates. As a result, in times of changing interest rates, decreases in
the difference or spread between the yield received on loans and other
investments and the rate paid on borrowings will occur.
15
The following tables reflect the average yields earned and rates paid
during the six months ended June 30, 2002 and 2001. In computing the
average yields and rates, the accretion of loan fees is considered an
adjustment to yield. Information is based on average month-end balances
during the indicated periods.
(Dollar in thousands) June 30, 2002 June 30, 2001
------------------------------------ ---------------------------------
Average Average Average Average
Balance Interest Yield/Rate Balance Interest Yield/Rate
-------- -------- ---------- -------- -------- ----------
Interest-earning assets:
Loan receivable (1) $ 46,429 $ 2,081 8.96% $ 53,506 $ 2,731 10.21%
Cash and other interest-
earning assets 29,629 203 1.37% 9,316 140 3.02
-------- -------- ---------- -------- -------- ----------
76,058 2,284 6.00% 62,822 2,871 9.14%
-------- ---------- -------- ----------
Non-interest-earning assets:
Allowance for loan losses (1,508) (1,445)
Premises and equipment, net 3,657 5,227
Other 4,927 7,814
-------- --------
Total assets $ 83,134 $ 74,418
======== ========
Interest-bearing liabilities:
Revolving warehouse lines $ 7,887 227 5.75% $ 4,169 157 7.50%
FDIC - insured deposits 63,390 1,169 3.69% 45,738 1,362 5.96
Other interest-bearing
liabilities 6,343 317 10.01% 12,777 478 7.48
-------- -------- ---------- -------- -------- ----------
77,620 1,713 4.41% 62,684 1,997 6.37%
-------- ---------- -------- ----------
Non-interest-bearing liabilities 1,548 4,344
-------- --------
Total liabilities 79,168 67,028
Shareholders' equity 3,966 7,390
-------- --------
Total liabilities and equity $ 83,134 $ 74,418
======== ========
Average dollar difference between
interest-earning assets and
interest-bearing liabilities $ (1,562) $ 138
======== ========
Net interest income $ 571 $ 874
======== ========
Interest rate spread (2) 1.59% 2.77%
========== ==========
Net annualized yield on average
Interest-earning assets 1.50% 2.78%
========== ==========
- ----------
(1) Loan's shown gross of allowance for loan losses, net of
premiums/discounts.
(2) Average yield on total interest-earning assets less average rate paid
on total interest-bearing liabilities.
16
The following table shows the change in net interest income, which can be
attributed to rate (change in rate multiplied by old volume) and volume (change
in volume multiplied by old rate) for the six months ended June 30, 2002
compared to the six months ended June 30, 2001. The changes in net interest
income due to both volume and rate changes have been allocated to volume and
rate in proportion to the relationship of absolute dollar amounts of the change
of each. The table demonstrates that the decrease of $303,000 in net interest
income for the six months ended June 30, 2002 compared to the six months ended
June 30, 2001 was primarily the result of decreases in the average balance and
rates on interest-earning assets.
(In thousands)
Six months ended June 30,
2002 Versus 2001
Increase (Decrease) due to:
--------------------------------------------
Volume Rate Total
------------ ----------- -----------
Interest-earning assets:
Loans receivable $ (338) $ (312) $ (650)
Cash and other interest-earning assets 84 (21) 63
------------ ----------- -----------
(254) (333) (587)
------------ ----------- -----------
Interest-bearing liabilities:
Revolving warehouse lines 95 (25) 70
FDIC-insured deposits (14,250) 14,057 (193)
Other interest-bearing liabilities (483) 322 (161)
------------ ----------- -----------
(14,638) 14,354 (284)
------------ ----------- -----------
Net interest expense $ 14,384 $ (14,687) $ (303)
============ =========== ===========
OTHER INCOME
In addition to net interest income (expense), and gain on sale of loans, we
derive income from other fees earned on the loans funded such as broker fee
income, underwriting service fees, prepayment penalties and late charge fees for
delinquent loan payments. Revenues associated with the financial products
marketed by Approved Financial Solutions are also recorded in other income. For
the three and six months ended June 30, 2002, other income totaled $0.4 and $0.9
million compared to $0.9 and $1.6 million for the same period in 2001. The level
of other income was affected by a reduction in the retail division, which
marketed the financial products offered by AFS and generated broker fee income
on loans brokered to other lenders. Broker fee income for the six month period
ended June 30, 2002 was $5,500 compared to $431,000 for the same period in 2001.
COMPREHENSIVE INCOME/LOSS
For the three and six months ended June 30, 2001 we had other comprehensive
income of $2,000 and $9,000 in the form of unrealized gains/losses on an Asset
Management Fund investment. For the three and six months ended June 30, 2002, we
had no other comprehensive income or loss.
17
COMPENSATION AND RELATED EXPENSES
The largest component of expenses is compensation and related expenses, which
decreased by $1.3 million and $2.4 million to $1.5 million and $3.1 million for
the three and six months ended June 30, 2002 compared to the same period in
2001. The decrease was directly attributable to a decrease in the number of
employees, related to our closure of retail loan origination offices,
productivity enhancement and cost cutting initiatives. For the three and six
months ended June 30, 2002, salary expense decreased by $0.6 million and $1.4
million when compared to the same period in 2001. The payroll related benefits
decreased by $0.2 million and $0.4 million for the three and six months ended
June 30, 2002 when compared to the same period in 2001. For the three and six
months ended June 30, 2002 the commissions to sales staff decreased by $0.4
million and $0.6 million when compared to the same periods ended June 30, 2001.
The decrease was primarily due to lower loan volume. For the three and six
months ended June 30, 2002, the average full time equivalent employee count was
85 and 94 compared to 167 and 185 for the three and six months ended June 30,
2001.
GENERAL AND ADMINISTRATIVE EXPENSES
General and administrative expenses are comprised of various expenses such as
rent, postage, printing, general insurance, travel and entertainment, telephone,
utilities, depreciation, professional fees and other miscellaneous expenses.
General and administrative expenses for the three and six months ended June 30,
2002 decreased by $0.4 million and $1.0 million to $1.1 million and $2.3
million, compared to the three and six months ended June 30, 2001. The decrease
was the result of a reduction in retail loan origination offices and the related
marketing expense, a decline in our employee count and cost cutting efforts
including cost savings through technology.
LOAN PRODUCTION EXPENSE
Loan production expenses are comprised of expenses for appraisals, credit
reports, payment of fees to mortgage brokers for services rendered on loan
originations and verification of mortgages. Loan production expenses for the
three and six months ended June 30, 2002 were $0.3 million and $0.7 million
compared to $0.7 million and $1.0 million for the three and six months ended
June 30, 2001. The reduction was primarily due to the decrease in loan
origination volume.
18
PROVISION FOR LOAN LOSSES
The following table presents the activity in the allowance for loan losses for
held for yield (HFY) loans which include general and specific allowances and
selected loan loss data for the six months ended June 30, 2002 and the year
ended December 31, 2001:
(Dollar in thousands)
2002 2001
-------------- --------------
Balance at beginning of year $ 880 $ 1,479
(Credit) provision charged to expense (212) 91
Loans charged off (131) (746)
Recoveries of loans previously charged off 31 56
-------------- --------------
Balance at end of period $ 568 $ 880
============== ==============
HFS loans receivable, gross of valuation allowance and deferred fees $ 21,872 $ 48,464
HFY loans receivable, gross of allowance for losses and deferred fees $ 8,655 $ 11,347
HFS and HFY loans receivable, gross of allowance for losses $ 30,527 $ 59,811
Ratio of allowance for loan losses to gross loans receivable at the end
of periods 1.86% 1.47%
* Valuation Allowance charges for HFS loans not recorded in allowance for loan
losses.
The credit for loan losses was $212,000 for the six months ended June 30, 2002
compared to a provision of $91,000 for the year ended December 31, 2001. The
provision for loan losses is based on management's assessment of the loan loss
risk for the associated loans. For the six months ended June 30, 2002, the net
decrease in the allowance for loan losses was primarily due to the change in
loss reserve methodology integrating the valuation allowance for HFS loans
beginning in the second quarter of 2001. The valuation allowance for HFS loans
is charged as an expense to income reducing the book value of the HFS loan
receivable and is not included in allowance for loan losses or in calculation of
regulatory capital ratios. The valuation allowance provisions for loans held for
sale and the allowance for loan losses on loans held for yield are established
at levels that we consider adequate to cover future loan losses relative to the
composition of the current portfolio of loans. We consider characteristics of
our current loan portfolio such as credit quality, the weighted average coupon
rate, the weighted average loan to value ratio, the combined loan to value
ratio, the age of the loan portfolio, recent loan sale pricing for loans with
similar characteristics, estimated net realizable value of loans, and the
portfolio's delinquency and loss history and current status in the determination
of an appropriate allowance. Other criteria such as covenants associated with
our credit facilities, regulatory reserve requirements, trends in the demand for
and pricing for loans sold in the secondary market for similar mortgage loans
and general economic conditions, including interest rates, are also considered
when establishing the allowance. Adjustments to the reserve for loan losses may
be made in future periods due to changes in the factors mentioned above and any
additional factors that may effect anticipated loss levels in the future. The
valuation allowance for HFS loans was decreased $149,000 to $648,000 in the six
months ended June 30, 2002. The ratio of the $648,000 valuation allowance for
HFS loans to $21.9 million gross HFS loans as of June 30, 2002 was 2.96%
compared to the ratio of 1.27% from the $617,000 valuation allowance for HFS
loans to $48.5 million gross HFS loans as of December 31, 2001.
19
The combined allowance for loan losses held for yield loans, $568,000, and
valuation allowance for held for sale loans, $648,000, as of June 30, 2002 were
$1.2 million or 3.93% of total gross held for yield and held for sale loans,
$30.5 million. As of December 31, 2001, the combined allowance for loan losses
held for yield loans, $880,000, and valuation allowance for held for sale loans,
$617,000, were $1.5 million or 2.50% of total gross held for yield and held for
sale loans, $59.8 million.
PROVISION FOR FORECLOSED PROPERTY LOSSES
The provision for foreclosed property losses was $280,000 for the six months
ended June 30, 2002 compared to $236,000 for the year ended December 31, 2001.
The allowance for REO losses increased for the six months ended June 30, 2002,
compared to December 31, 2001 due to the change in loss reserve methodology
adopted in the later half of 2001 to comply with regulatory guidance and an
increase in the gross amount of foreclosed property. The allowance in 2002 was
established such that the book value of the asset reflects the estimated net
realizable value of the underlying property. Sales of real estate owned yielded
net losses of $101,000 for the six months ended June 30, 2002 versus $198,000
for the six months ended June 30, 2001.
The following table presents the activity in the allowance for foreclosed
property losses and selected real estate owned data for the six months ended
June 30, 2002 and the year ended December 31, 2001:
(Dollar in thousands)
2002 2001
-------------- --------------
Balance at beginning of year $ 113 $ 377
Provision charged to expense 280 236
Loss on sale of foreclosures (101) (500)
-------------- --------------
Balance at end of period $ 292 $ 113
============== ==============
Real estate owned at the end of period, gross
of allowance for losses $ 1,343 $ 702
Ratio of allowance for foreclosed property losses
to gross real estate owned at the end of period 21.7% 16.1%
Assets acquired through loan foreclosure are recorded as real estate owned
("REO"). When a property is transferred to REO status a new appraisal is ordered
on the property. The property is written down to the net realizable value of the
property, which is the listed or appraised value less cost to carry and
liquidate. While we believe that our present allowance for foreclosed property
losses is adequate, future adjustments may be necessary.
20
FINANCIAL CONDITION
ASSETS
The total assets were $54.4 million at June 30, 2002, compared to total assets
of $78.5 million at December 31, 2001.
Cash and cash equivalents increased by $6.3 million to $17.9 million at June 30,
2002, from $11.6 million at December 31, 2001. The principal reason for the
increase for the period ending June 30, 2002 was the receipt of proceeds from
loan sales in the final week of June 2002. These proceeds are use to fund new
loans in July 2002.
Net mortgage loans receivable decreased by $29.0 million to $29.2 million at
June 30, 2002. The 49.8% decrease in the first six months of 2002 is primarily
due to selling more loans than were originated during the first six months of
2002. We generally sell loans within sixty days of origination.
Real estate owned ("REO") increased by $0.5 million to $1.1 million at June 30,
2002. The 78.6% increase in REO resulted from the sale of $0.4 million in REO
properties compared to additions of $1.0 million to REO during the six months
ended June 30, 2002.
Investments consist of FHLB stock owned by the Bank. There were no changes
during the six months ended June 30, 2002.
Premises and equipment decreased by $0.3 million to $3.5 million at June 30,
2002. The decrease is due to the depreciation of these assets for the six months
ended June 30, 2002.
The deferred tax asset decreased by $1.6 million to $0 at June 30, 2002. The
decrease is related to an increase in the valuation allowance for the deferred
tax asset during the six-month period.
Other assets remained unchanged at $1.6 million at June 30, 2002. Other assets
consist of accrued interest receivable, prepaid assets, brokered loan fees
receivable, deposits, and various other assets.
LIABILITIES
Outstanding balances for our revolving warehouse loans decreased by $0.2 million
to $3.1 million at June 30, 2002. The decrease in 2002 was primarily
attributable to the timing of loans sales.
The Bank's deposits totaled $38.9 million at June 30, 2002, compared to $59.9
million at December 31, 2001. Of the certificate accounts on hand as of June 30,
2002, a total of $35.3 million was scheduled to mature in the twelve-month
period ending June 30, 2003.
Through an arrangement with a local NYSE member broker/dealer, we held $1.7
million and $2.2 million in FDIC insured money market deposits as of June 30,
2002 and December 31, 2001, respectively.
Promissory notes and certificates of indebtedness totaled $4.7 million at June
30, 2002 compared to $4.6 million at December 31, 2001. During the six months
ended June 30, 2002 and the year of 2001, we did not solicit new promissory
notes or certificates of indebtedness. We have utilized promissory notes and
certificates of indebtedness, which are subordinated to FDIC insured deposits
and our warehouse lines of credit, to help fund operations since 1984.
Promissory notes outstanding carry terms of one to
21
five years and interest rates between 8.0% and 10.0%, with a weighted-average
rate of 9.74% at June 30, 2002. Certificates of indebtedness are uninsured
indebtedness authorized for financial institutions, which have Virginia
Industrial Loan Association charters. The certificates of indebtedness carry
terms of one to five years and interest rates between 6.75% and 10.50%, with a
weighted-average rate of 9.74% at June 30, 2002.
Mortgage loans payable remained unchanged at $1.7 million at June 30, 2002. This
loan decreases due to the normal principal reduction with payments made on the
mortgage note payable.
Accrued and other liabilities remained unchanged at $1.4 million at June 30,
2002. This category includes accounts payable, accrued interest payable,
deferred income, and other payables.
SHAREHOLDERS' EQUITY
Total shareholders' equity at June 30, 2002 was $2.9 million compared to $5.4
million at December 31, 2001. The $2.5 million decrease in 2002 was due to the
net loss for the six months ended June 30, 2002, which includes the deferred tax
asset valuation allowance increase of $1.6 million.
LIQUIDITY AND CAPITAL RESOURCES
Our operations require access to short and long-term sources of cash. Our
primary sources of cash flow result from the sale of loans through whole loan
sales, loan origination fees, processing, underwriting and other fees associated
with loan origination and servicing, revenues generated by Approved Financial
Solutions and Global Title of Md., Inc., net interest income, and borrowings
under our warehouse facilities, certificates of indebtedness issued by Approved
Financial Corp. and FDIC insured deposits issued by the Bank to meet working
capital needs. Our primary operating cash requirements include the funding of
mortgage loan originations pending their sale, operating expenses, income taxes
and capital expenditures.
Adequate credit facilities and other sources of funding, including the ability
to sell loans in the secondary market, are essential to our ability to continue
to originate loans. We have historically operated, and expect to operate in the
future, on a negative cash flow basis from operations based upon the timing of
proceeds used to fund loan originations and the subsequent receipt of cash from
the sale of the loan. Loan sales normally occur 30 to 60 days after proceeds are
used to fund the loan. For the six months ended June 30, 2002, we received cash
from operating activities of $27.6 million. For the six months ended June 30,
2001, we used cash in operating activities of $23.1 million.
We finance our operating cash requirements primarily through FDIC-insured
deposits, warehouse and other debt. For the six months ended June 30, 2002, we
decreased debt from financing activities of $21.6 million. This was primarily
the result of decreases in certificates of deposits. For the six months ended
June 30, 2001, we increased debt from financing activities of $25.8 million.
This was primarily the result of increases in certificates of deposits.
Our borrowings (revolving warehouse and other credit facilities, FDIC-insured
deposits, mortgage loans on our office building and subordinated debt) were
92.2% of assets at June 30, 2002 compared to 91.3% at December 31, 2001.
22
WHOLE LOAN SALE PROGRAM
The most important source of liquidity and capital resources is the ability to
sell conforming and non-conforming loans in the secondary market. The market
value of the loans funded is dependent on a number of factors, including but not
limited to loan delinquency and default rates, the original term and current age
of the loan, the interest rate and loan to value ratio, whether or not the loan
has a prepayment penalty, the credit grade of the loan, the credit score of the
borrower, the geographic location of the real estate, the type of property and
lien position, the supply and demand for conforming and non-conforming loans in
the secondary market, general economic and market conditions, market interest
rates and governmental regulations. Adverse changes in these conditions may
affect our ability to sell mortgages in the secondary market for acceptable
prices, which is essential to the continuation of our mortgage origination
operations.
BANK SOURCES OF CAPITAL
The Bank's deposits totaled $40.6 million at June 30, 2002 compared to $62.1
million at December 31, 2001. The Bank currently utilizes funds from deposits
and warehouse lines of credit to fund first lien and junior lien mortgage loans.
We plan to increase the use of credit facilities and seek additional funding
sources in future periods.
WAREHOUSE AND OTHER CREDIT FACILITIES
In December 2001 we obtained a $15.0 million warehouse line of credit
(structured as a repurchase agreement) with another financial institution. The
size of the facility was increased to $25 million as of June 2002. The interest
rate associated with the facility is prime plus 1.25%. The line has various
financial requirements including a minimum tangible net worth of $916,000. As of
June 30, 2002, we were in compliance with all financial covenants.
In November 2001, we obtained a $7.0 million bank line of credit. This facility
was terminated in 2002 upon determination by management that the line was not
designed administratively to meet the Company's funding needs in a cost
efficient manner.
23
OTHER CAPITAL RESOURCES
Uninsured promissory notes and certificates of indebtedness issued by Approved
Financial Corp. have been a source of capital since 1984 and are issued
primarily according to an intrastate exemption from security registration.
Promissory notes and certificates of indebtedness totaled $4.7 million at June
30, 2002 compared to $4.6 million at December 31, 2001. These borrowings are
subordinated to FDIC insured deposits and our warehouse lines of credit. We
cannot issue subordinated debt to new investors under the exemption since the
state of Virginia is no longer our primary state of operation.
We had cash and cash equivalents of $17.9 million at June 30, 2002. We have
sufficient resources to fund our current operations. Sources for future
liquidity and capital resource needs may include private security sales, the
public issuance of debt or equity securities, increase in FDIC insured deposits
and new lines of credit. Current corporate initiatives included the procurement
of new investment of equity capital. Each alternative source of liquidity and
capital resources will be evaluated with consideration for maximizing
shareholder value, regulatory requirements, the terms and covenants associated
with the alternative capital source. We expect that we will continue to be
challenged by a limited availability of capital, fluctuations in the market
price of and premiums received on whole loan sales in the secondary market
compared to premiums realized in prior years, new competition in the mortgage
loan origination industry and a slow economic environment leading to a possible
rise in loan delinquency and the associated loss rates.
BANK REGULATORY LIQUIDITY
Liquidity is the ability to meet present and future financial obligations,
either through the acquisition of additional liabilities or from the sale or
maturity of existing assets, with minimal loss. Regulations of the OTS require
thrift associations and/or banks to maintain liquid assets at certain levels. At
present, the required ratio of liquid assets to borrowings, which can be
withdrawn and are due in one year or less is 4.0%. Penalties are assessed for
noncompliance. During the six months ending June 30, 2002 and in 2001, the Bank
maintained liquidity in excess of the required amount, and we anticipate that we
will continue to do so.
24
BANK REGULATORY CAPITAL
At June 30, 2002, the Bank's book value under accounting principles generally
accepted in the United States (US GAAP) was $5.3 million. OTS Regulations
require that institutions maintain the following capital levels: (1) tangible
capital of at least 1.5% of total adjusted assets, (2) core capital of 4.0% of
total adjusted assets, and (3) overall risk-based capital of 8.0% of total
risk-weighted assets. As of June 30, 2002, the Bank satisfied the regulatory
capital requirements, as shown in the following table reconciling the Bank's
GAAP capital to regulatory capital:
Tangible Core Risk-Based
(Dollar in thousands) Capital Capital Capital
----------- ----------- -----------
GAAP capital $ 5,285 $ 5,285 $ 5,285
Non-allowable asset: goodwill (71) (71) (71)
Additional capital item: general allowance - - 300
----------- ----------- -----------
Regulatory capital - computed 5,214 5,214 5,514
Minimum capital requirement 795 2,120 2,622
----------- ----------- -----------
Excess regulatory capital $ 4,419 $ 3,094 $ 2,892
=========== =========== ===========
Ratios:
Regulatory capital - computed 9.84% 9.84% 16.82%
Minimum capital requirement 1.50% 4.00% 8.00%
----------- ----------- -----------
Excess regulatory capital 8.34% 5.84% 8.82%
=========== =========== ===========
OTS CEO Memorandum #137 issued in February of 2001 requires that the bank's
board of directors determine the appropriate minimum capital level for the
institution relative to 'subprime' lending activity. The determination of an
appropriate minimum capital ratio related to subprime lending activities is a
dynamic process based on quantifiable statistics related to the composition and
performance of actual assets owned by the institution at a static point in time
and theoretical variables such as current market and economic conditions and
expectations for the future. The quantifiable variables include items such as
loan portfolio designations between 'held for yield' and 'held for sale' and the
related allowance for loan and lease loss and valuation allowance charges,
statistics related to the credit quality of current loan portfolio outstanding,
factors including asset performance and historical default trends, and recent
secondary loan sale market transactions. We believe that our capital ratios as
of June 30, 2002 are appropriate for the risk related to our current lending
activity and loan portfolio. This determination is primarily based on the fact
that all current loan origination activity is underwritten with intent to sell
to investors and according to our investors' underwriting guidelines and current
methodology used to determine loan loss reserves either as allowance for loan
and lease losses (ALLL) or valuation allowances for held for sale loans.
25
BANK REGULATORY MATTERS
As disclosed in the 10K filing for December 31, 2001 and the 10Q filings for
March 31, 2001, June 30, 2001 and September 30, 2001, the Office of Thrift
Supervision (the "OTS") issued a written directive to Approved Financial Corp.
("AFC") and Approved Federal Savings Bank ("AFSB") dated April 20, 2001, stating
that as a result of AFSB's practice of assigning loans to AFC, its holding
company, it was declaring AFSB a "problem association" and was declaring AFC in
"troubled condition" as set forth in applicable laws and regulations.
The practice of inter-company loan assignments had been standard operating
procedure between AFSB and AFC for several years. This operating procedure was
disclosed during prior audits, including audits by the Company's independent
public accountants and has no effect on previously audited consolidated
financial statements. The Board of Directors of AFSB and AFC acknowledge and
respect the authority and power of the OTS and acted promptly to implement
corrective actions requested by the OTS.
Management and the Boards of Directors revised and implemented inter-company
operating procedures as submitted to the OTS. The Board of Directors of the Bank
entered into a Consent Supervisory Agreement ("Agreement") with the Office of
Thrift Supervision on December 3, 2001, as filed on Form 8K. As of June 30,
2002, to the best of our knowledge, we are in compliance with the Agreement.
INTEREST RATE RISK MANAGEMENT
We mitigate our interest rate exposure and the related need for hedging activity
by means of our current policy to originate all loans with intent to sell,
within sixty days of origination. Since the majority of our borrowings have
fixed interest rates, we have exposure to interest rate risk. For example, if
market interest rates were to rise between the time we originate the loans and
the time the loans are sold, the original interest rate spread on the loans
narrows, resulting in a loss in value of the loans.
In recent years, pricing for our product offering rate sheets was normally
adjusted upon receipt of notice from investors of changes in their pricing
criteria. Pricing of a loan approval is normally honored if the loan is closed
within a fifteen-day period. Therefore, to mitigate the risks associated with
interest rate fluctuations our secondary marketing division now monitors the
daily market prices and associated interest rate yields of bonds and/or other
market interest rates used by investors as benchmarks for pricing pools of loans
and adjusts our product offering rate sheets based on material changes as deemed
appropriate, which may be before pricing change notice has been received from
the investor. In certain cases we may enter into forward loan sale commitments
with investors and/or make use of similar transactions such as mandatory loan
sales. Under these arrangements, we are normally allowed an agreed number of
days to deliver a specified amount of loans meeting the investor's underwriting
criteria and according to a prearranged pricing formula. Under these agreements,
the investor assumes the interest rate risk for the agreed time period and we
are obligated to deliver the loan volume. Since the investor is normally a
larger institution that purchases pools of loans from many investors under
similar agreements, the investor utilizes the advantages from economy of scale
and can implement a cost effective hedging strategy to mitigate the assumed
interest rate risk. Therefore, we will use this strategy to mitigate interest
rate risk when the appropriate opportunities are presented based on overall risk
reward evaluation.
In the future, the Board may determine it appropriate to adopt a more complex
interest rate hedging strategy and may enter into typical transactions such as
short sales of U.S. Treasury securities. Any type of hedge transaction or
forward loan sale commitment, is evaluated on a risk reward basis and intended
to limit our exposure to interest rate risk.
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We had no hedge contracts or forward commitments outstanding at June 30, 2002.
We have not entered into any hedge contracts since the fourth quarter of 1997.
NEW ACCOUNTING STANDARDS
In September 2000, the FASB issued SFAS No. 140, Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities, a replacement
of SFAS No. 125. It revises the standards for accounting for securitizations and
other transfers of financial assets and collateral and requires certain
disclosures, but it carries over most of provisions of SFAS No. 125 without
reconsideration. The Statement requires a debtor to reclassify financial assets
pledged as collateral and report these assets separately in the statement of
financial position. It also requires a secured party to disclose information,
including fair value, about collateral that it has accepted and is permitted by
contract or custom to sell or re-pledge. The Statement includes specific
disclosure requirements for entities with securitized financial assets and
entities that securitize assets. This Statement is effective for transfers and
servicing of financial assets and extinguishments of liabilities occurring after
March 31, 2000 and is effective for recognition and reclassification of
collateral and for disclosures relating to securitization transactions and
collateral for fiscal years ending after December 15, 2000. FAS 140 did not have
a material effect on financial condition or results of operations.
In July 2001, FASB issued SFAS No. 142, "Goodwill and Other Intangible Assets."
SFAS No. 142 requires the use of a non-amortization approach to account for
purchased goodwill and certain intangibles, effective January 1, 2002. This did
not have a material effect on financial condition or results of operations.
IMPACT OF INFLATION AND CHANGING PRICES
The consolidated financial statements and related data presented in this
document have been prepared in accordance with US GAAP, which requires the
measurement of the financial position and operating results in terms of
historical dollars, without considering changes in the relative purchasing power
of money over time due to inflation.
The majority of the assets are monetary in nature. As a result, interest rates
have a more significant impact on our performance than the effects of general
levels of inflation. Inflation affects us most significantly in the area of
residential real estate values and inflation's effect on interest rates. Real
estate values generally increase during periods of high inflation and are
stagnant during periods of low inflation. While interest rates do not
necessarily move in the same direction or with the same magnitude as the prices
of goods and services, normally, interest rates increase during periods of high
inflation and decrease during periods of low inflation.
Loan origination volume generally increases as residential real estate values
increase because homeowners have new home equity values against which they can
borrow. A large portion of our loan volume is related to refinancing and debt
consolidation mortgages; therefore, an increase in real estate values enhances
the marketplace for this type of loan origination. Conversely, as residential
real estate values decrease, the market for home equity and debt consolidation
loan origination decreases. Additionally, an increase or decrease in residential
real estate values may have a positive or negative effect, respectively, on the
liquidation of foreclosed property.
The loans we originate are intended for sale in the whole loan secondary market;
therefore, the effect on interest rates from inflation trends has a diminished
effect on the results of operations. However, the
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portfolio of loans held for yield, is more sensitive to the effects of inflation
and changes in interest rates. Profitability may be directly affected by the
level and fluctuation of interest rates, which affect our ability to earn a
spread between interest received on loans and the costs of borrowings. Our
profitability is likely to be adversely affected during any period of unexpected
or rapid changes in interest rates. (See also: "Interest Rate Risk Management").
A substantial and sustained increase in interest rates could adversely affect
our ability to originate and purchase loans and affect the mix of first and
junior lien mortgage loan products. Generally, first mortgage production
increases relative to junior lien mortgage production in response to low
interest rates and junior lien mortgage loan production increases relative to
first mortgage loan production during periods of high interest rates.
While we have no plans to adopt a Securitization loan sale strategy at this
time, if we were to do so in the future, then to the extent loan servicing
rights and interest-only and residual classes of certificates are capitalized on
the books ("capitalized assets") from future loan sales through securitization,
higher than anticipated rates of loan prepayments or losses could require us to
write down the value of capitalized assets, adversely affecting earnings. A
significant decline in interest rates could increase the level of loan
prepayments. Conversely, lower than anticipated rates of loan prepayments or
lower losses could allow us to increase the value of capitalized assets, which
could have a favorable effect on our results of operations and financial
condition.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK MANAGEMENT - ASSET/LIABILITY MANAGEMENT
There have been no significant changes from the quantitative and qualitative
disclosures made in the December 31, 2001 Form 10K.
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PART II. OTHER INFORMATION
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Item 1. LEGAL PROCEEDINGS
Mr. Barry Epstein, former managing director of the West Wholesale Division of
Approved Federal Savings Bank, filed a lawsuit in the U.S. Federal District
Court, Eastern Division, against Approved Financial Corp., Approved Federal
Savings Bank, and certain current and former officers. The complaint asserts
twelve (12) counts, including breach of contract, fraud, RICO, tortious
interference with contract, and others. He seeks to recover a $200,000
investment of capital and between $5 million and $20.2 million in alleged lost
profits. The defendants have filed a motion to strike several of the counts. The
defendants intend to defend the lawsuit vigorously and intend to file a
counterclaim.
Item 2. CHANGES IN SECURITIES - None
Item 3. DEFAULTS UPON SENIOR SECURITIES - None
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - None
Item 5. OTHER INFORMATION - None
Item 6. EXHIBITS AND REPORTS ON FORM 8-K - None
The undersigned, as the chief executive officer of Approved Financial Corp.,
certify that the Form 10-Q for the quarter ended June 30, 2002, which
accompanies this certification fully complies with the requirements of Section
13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934 and the
information contained in the periodic report fairly presents, in all material
respects, the financial condition and results of operations of Approved
Financial Corp. at the dates and for the periods indicated. The foregoing
certification is made solely for purposes of Title 18, Chapter 63, Section 1350
of the United States Code and is subject to the knowledge and willfulness
qualifications contained in Title 18, Chapter 63, Section 1350(c).
Date: August 14, 2002 By: /s/ Allen D. Wykle
--------------- ---------------------------------
Allen D. Wykle
Chairman, President, and Chief Executive
Officer
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